Category: Pension Newsroom

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Attracta Mooney of the Financial Times reports, The US public pensions crisis ‘is really hard to fix’:

Eighteen months after Rahm Emanuel, a former White House chief of staff, became mayor of Chicago, he addressed a news conference about his priorities.

“[Number] one is retirement security and pension reform so we can give taxpayers and the public employees retirement security, which is something we can’t say today,” the mayor said in November 2012.

In the following three and a half years, Chicago’s public pension system, which estimates suggest has a funding hole of between $20bn and $32.5bn, has cast a long shadow over the mayor.

There have been rows with unions, court battles and finally a credit downgrade for the city, all linked to the Chicago’s public pensions.

Similar stories are playing out across the US. Although the funding deficits might not be as extreme as in Chicago, many cities and states are struggling under the weight of their pension plans, which oversee the retirement incomes of current and past public sector employees.

The scale of this pension crisis, as it has been dubbed, is huge. The Hoover Institution, a think-tank at Stanford University, estimates that US public pensions collectively have a $3.4tn funding hole. More conservative numbers put the funding gap at around $1tn.

Few public pension plans are fully funded, meaning they do not have enough money to pay current and future retirees. And the situation is getting worse.

According to Wilshire Consulting, an investment advisory company, state-sponsored pension plans in the US had just 73 per cent of the assets they needed in mid-2015, down from 77 per cent in 2014. Turbulent market conditions in the latter part of 2015 and early 2016 probably made this number even worse.

The big questions are if and how the large funding holes that have emerged in the US public pension system can be fixed.

Chris Tobe, an investment consultant and author of Kentucky Fried Pensions, a book examining problems in Kentucky’s retirement system, says the shortfalls in most US public pension plans are fixable, but there are exceptions, such as Chicago.

However, fixing the schemes will require a lot of work and is likely to have unpleasant consequences for retirees, employees, taxpayers and politicians.

One area where this is apparent is when state and local governments increase or introduce taxes, using the money raised to plug pension shortfalls. Several cities, including Chicago and Philadelphia, have taken this route.

But higher taxes or the issuance of bonds, another option used by local governments to raise money in order to reduce pension deficits, often proves unpopular with taxpayers.

Tamara Burden, principal at Milliman Financial Risk Management, an investment adviser to pension funds, says: “Raising taxes and issuing bonds means a vote, and a lot of public entities have seen those initiatives not pass.

“[The large-scale underfunding of public pensions] is really hard to fix.”

In Chicago, Ed Bachrach, chairman of the Center for Pension Integrity, a non-profit organisation, estimates that to ensure the city’s pension plans are fully funded within 20 years, Chicago’s property tax would have to be increased 85 per cent. But he warns that “crippling tax increases” could drive taxpayers and businesses away.

Mr Bachrach adds: “In troubled jurisdictions, officials cannot raise taxes fast enough to prevent the erosion of fund assets, and the enormous pension payments required are crowding out expenditure for vital public services and crumbling infrastructure.”

There are other options available to improve the outlook for public pension plans. One is making changes within pension funds that would help to drive funding deficits down, such as cutting the fees retirement plans pay to asset managers. Some pensions are pushing into riskier assets in the hope that this will increase returns.

Alternatively, state and local governments could reduce benefits for current or future retirees, or cap the maximum retirement benefit that can be paid to an individual. These measures are illegal in some states and have proved unpopular with unions and public sector workers.

Public sector workers could also be forced to increase their contributions, or moved into defined contribution plans, which do not guarantee a level of income on retirement. This would, in turn, reduce the strain on local government budgets.

Any attempt to fix the pension shortfall is likely to involve a combination of these solutions. But there seems to be an unwillingness to fix the problems, according to Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania.

Unions, public sector employees and retirees do not want to give up the benefits promised to them, politicians do not want to impose tax hikes that could cost them votes, and taxpayers are reluctant to part with more cash to prop up the system.

Ms Mitchell says: “Politicians and taxpayers have shown themselves unwilling to take their public pension shortfalls seriously.”

Mr Bachrach adds: “Fixing this problem requires shared sacrifice from all parties: public employees, retirees and taxpayers. It requires courage on the part of elected officials.”

If the problems are not fixed, the consequences could be dire.

Some pension funds, including two of Chicago’s plans, are on course to run out of money within a matter of years. This means that either the retirees will not get paid the money they are owed, or, more likely, the cities and states that back the pension plans will have to cover the retirement payments.

This would leave cities and states with less money to spend on services such as education. In some cases, cities may go bankrupt. This has already happened in Detroit in Michigan and San Bernardino in California, where large public pension shortfalls contributed to the cities’ defaults.

“I do believe that US cities and towns will continue to suffer [because of their pension funding holes], and there will be additional bankruptcies following the examples of Detroit,” said Ms Mitchell earlier this year.

Some pension officials are hoping the federal government will step in and prop up problematic retirement funds. But Devin Nunes, a US Republican congressman, is trying to make sure this does not happen.

He proposed a bill in March to ensure the federal government cannot rescue insolvent public pension funds. “Cities and states should run [pension funds] in a financially sustainable way. That is what my bill encourages, particularly by prohibiting federal bailouts of distressed funds,” he says.

Even without the bill, Steven Hess, an analyst at Moody’s, the rating agency, says states and cities will have to fix their own pension problems. “We don’t think the federal government will come to the rescue of municipal plans,” he says.

Phil Angelides, a former state treasurer for California who used to sit on the board of Calpers and Calstrs, the US public pension schemes, says: “[The public pension deficit] is manageable if society begins to address it. A few pension funds may have immediate issues, but they face long-term challenges and there is still time to address them.”

As for Chicago, the future of its pension funds remains unclear. In March, Illinois’s Supreme Court ruled against Mr Emanuel’s plans to stabilise the pension funds by requiring larger employee contributions and cutting pension benefits in return for bigger contributions from the city.

In the wake of this ruling, a spokesperson for the mayor says: “We are currently evaluating a number of pension reform proposals.”

The mayor, it seems, faces an uphill battle to plug the city’s pension deficit.

US public pensions: ‘There is no young blood coming in’

The large funding holes that have emerged at US public pension plans have been decades in the making.

A combination of factors, ranging from demographics to current low interest rates, has left pension plans nursing big deficits.

In some cases, cities and state governments have not contributed as much as they should have to public pension plans, leaving funds without the money they needed to invest and plug any developing funding holes.

Another factor is that public pension plans have been underestimating how much money they would need in future, says Olivia Mitchell, a professor at the Wharton School at the University of Pennsylvania.

Public plans typically have high return targets of between 7 and 8 per cent, which are used to forecast how much money a pension fund will need to pay current and future retirees. Private sector pension plans, in contrast, typically use lower rates of 2.5 per cent on average to calculate future liabilities, says Ms Mitchell.

Every time a public pension plan misses the return target, their liabilities jump. They then need far stronger performance the following year in order to correct the problem.

An ageing public sector population is not helping matters. “There is no young blood coming in to keep their plans going,” says Ms Mitchell.

I’ve already covered why U.S. public pensions are doomed. It’s a slow motion train wreck and while demographics and historic low rates aren’t helping, in my opinion, terrible pension governance is equally if not a more important determinant of the U.S. public pension crisis.

Here are some of the points I noted on why this crisis isn’t going away:

The critical point to remember is that when rates are at historic lows, every drop in global long bond yields represents a huge increase in future liabilities for pensions. Why? Because the duration of liabilities is a lot bigger than the duration of assets which means that every drop in bond yields disproportionately impacts pension deficits.

This is why you see Canada’s large public pensions scrambling to buy infrastructure assets like London City Airport at a hefty premium. They need to find assets that are a better match to their long dated liabilities. We can argue whether Canada’s mighty pensions are paying too much for these “premium infrastructure assets” (I think so) but this is the approach they’re taking to defy volatile public markets and find a better suitable match for their long dated liabilities.

And unlike the United States, Canada’s large public pensions have the right governance to go out to do these direct investments in infrastructure. Also, unlike their U.S. counterparts, Canada’s large public pensions have realistic investment assumptions and are better prepared for an era of lower returns.

In the U.S., public pensions are delusional, firmly holding on to the pension rate-of-return fantasy. They’re also held hostage by useless investment consultants that shove them in the same brand name private equity funds and hedge funds. This doesn’t always pan out well for these public pensions but it enriches private equity titans and hedge fund gurus who collect outrageous fees no matter how well they perform.

It’s worth noting none other than Warren Buffett came out this weekend to state hedge funds are getting ‘unbelievable’ fees for bad results:

“There’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities,” Buffett said Saturday during Berkshire’s annual meeting in Omaha, Nebraska.

I couldn’t agree more. I don’t pity any hedge fund manager, especially those “superstars” managing multibillions, collecting a big management fee no matter how poorly they’re performing.

The amount of nonsense governing hedge fund investments at U.S. public pensions is a byproduct of a few things: 1) delusional public pension fund managers who don’t know the first thing about managing a portfolio off hedge funds and 2) this irrational thirst for yield at all cost believing that hedge funds can offer great risk-adjusted returns in all cycles.

Dan Loeb is right, we are in the ‘1st inning of  a washout in hedge funds’ and the reason is simple: deflation is coming, which means low rates and huge market volatility are here to stay. Most hedge funds are going to get obliterated in this environment and large public pensions are quickly realizing this which is why they’re redeeming from even brand name funds.

In Canada, large public pensions are increasingly looking to invest directly in infrastructure assets around the world and at home. I don’t see them chasing after hedge funds or even private equity funds which charge enormous fees and deliver lackluster results.

But in the United States, you don’t have the right pension governance, which means you can’t attract and retain qualified pension fund managers to bring assets internally to invest directly across public and private markets, as well as engage in internal absolute return strategies instead of farming them out and getting clobbered on fees.

Warren Buffett is right, there is a tremendous amount of salesmanship going on in Wall Street and fees matter a lot, especially over a long period. But U.S. public pensions remain undeterred, feeling that investing in hedge funds will help them navigate the future a lot better (they’re in for a nasty surprise).

Now, forget hedge funds, let’s talk about the pension fixes discussed in the article above. When a public pension is severely underfunded, either you increase taxes, emit more pension bonds, increase the contributions or cut benefits. Or you can pray that monetary authorities will resurrect global inflation and interest rates will shoot up and all these public pension deficits will magically disappear (a higher discount rate means lower future liabilities).

Unfortunately, I have bad news for pensions that believe higher interest rates are coming. I’ve been warning them for a long time of the deflation tsunami and that ultra low rates and the new negative normal are here to stay.

In fact, last week, Bank of Canada Governor Stephen Poloz warned pensions to brace for a new normal of lower rates. I would go a step further and tell pensions to brace for negative rates and truly understand what they are (Sober Look published a great comment looking at misconceptions surrounding negative rates).

Again, maybe I’m too negative, maybe oil will experience a multi-year bull run even if the Saudis are hedging their bets, maybe Jamie Dimon is right on Treasuries, maybe Soros is wrong and China’s pension gamble will pay off, maybe the yen’s surge won’t trigger another Asian financial crisis, maybe monetary authorities can resurrect global inflation and maybe the quants and algos can engineer ever higher stock prices so we can escape the Great Crash of 2016.

Or maybe the bulls are drinking way too much Koolaid because from my vantage point, nothing has changed on a structural basis to change my Outlook 2016 as to why the global deflation tsunami is coming and it will wreak havoc on global pensions (all the big moves in risk assets leveraged to global growth were related to weakness in the U.S. dollar which will change abruptly in the second half of the year as the rest of the world slows down big time).

Something else you should all bear in mind. All these pension fixes being proposed, whether it’s cuts to benefits, increasing taxes and contributions, or worse still, shifting them into defined-contribution plans, are all very deflationary.

But hey, if you believe in fairy tales and think the world is going to magically grow its way out of these problems, be my guest. I prefer reality which is why I think the big money in the second half of the year will be shorting all these risks assets leveraged to global growth that benefited from the (temporary) weakness in the U.S. dollar.

As far as fixing U.S. public pensions, the problem is huge, much bigger than U.S. policymakers can possibly grasp and there are powerful special interests who don’t want to change the status quo (basically hedge funds, private equity funds and the rest of the Wall Street mob milking public pensions dry).

In my humble opinion, if America wants a real revolutionary retirement plan, it has to stop looking at Wall Street for solutions and start bolstering Social Security by adopting Canadian pension governance and the risk-sharing model which is working all over the world.

That’s the brutal truth. There is no magic fix for what is ailing U.S. public pensions and the problem is going to get a lot worse over the next decade(s) and it will hurt the U.S. economy in profound ways.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andy Blatchford of the Canadian Press reports, Pensions should brace for new normal of lower neutral interest rates:

Bank of Canada governor Stephen Poloz is recommending pension funds get ready for a new normal: neutral interest rates lower than they were before the financial crisis.

Poloz told a Wall Street audience Tuesday that the fate of neutral rates — the levels he said will prevail once the world economy recovers — remain unknown, but they will almost certainly be lower than previously thought.

The central banker made the comment during a question-and-answer period that followed his speech on global trade growth.

Among the reasons, Poloz pointed to the more-pessimistic outlook for potential long-term global growth. The forecast was lowered to 3.2 per cent from four per cent, he said.

“That downgrade means the neutral rate of interest will be lower for sure — for a very long time,” said Poloz, who added it could go even lower if economic “headwinds” continue.

“Those in the pension business need to get used to it. They need to adapt to it.”

Since the 2008 global financial crisis, pension funds around the world have had to contend with market uncertainty, feeble growth and record-low interest rates.

Pension funds use long-term interest rates to calculate their liabilities. The lower the rates, the more money plans need to have to ensure they will be able to pay future benefits.

A December report by the Organization for Economic Co-operation and Development said the conditions have “cast doubts on the ability of defined-contribution systems and annuity schemes to deliver adequate pensions.”

To cushion the Canadian economy from the shock of lower commodity prices, Poloz lowered the central bank’s key rate twice last year to 0.5 per cent — just above its historic low of 0.25.

Poloz linked the higher neutral interest rates of the past to the baby boom, which he described as a 50-year period of higher labour-force participation and better growth.

“Well, that’s behind us,” Poloz told the meeting of the Investment Industry Association of Canada and the Securities Industry and Financial Markets Association.

“We don’t have numbers for all this, but you need to be scenario-testing those pension plans and the needs of your clients because the returns simply won’t be there.”

But with all the unpredictability Poloz said it remains possible current headwinds could convert into positive forces that would push interest rates back to “more-normal levels” seen prior to the crisis.

Earlier Tuesday, Poloz’s speech touched on another aspect of the post-crisis world.

He told the crowd they shouldn’t expect to see a return of the “rapid pace of trade growth” the world saw for the two decades before the crisis.

Poloz was optimistic, however, that the “striking weakness” in international trade wasn’t a sign of a looming global recession.

He said the renewed slowdown in global exports is more likely a result of the fact that big opportunities to boost global trade have already been largely exploited.

As an example, he noted China could only join the World Trade Organization once.

Poloz expressed confidence that most of the trade slump will be reversed as the global economy recovers — even if it’s a slow process.

“The weakness in trade we’ve seen is not a warning of an impending recession,” said Poloz, a former president and CEO of Export Development Canada.

“Rather, I see it as a sign that trade has reached a new balance point in the global economy — and one that we have the ability to nudge forward.”

He said there’s still room to boost global trade through efficiency improvements to international supply chains, the signing of major treaties such as the Trans-Pacific Partnership and the creation of brand new companies.

Poloz’s speech came a day after Export Development Canada downgraded its outlook for the growth of exports.

EDC chief economist Peter Hall predicted overall Canadian exports of goods and services to expand two per cent in 2016, down from a projection last fall of seven per cent.

Well, if President Trump takes over after President Obama, you can expect more protectionism and trade wars, which isn’t good for global trade.

But Bank of Canada Governor Stephen Poloz is absolutely right, pensions need to brace for a new normal of lower neutral interest rates. I’ve long warned my readers that ultra low rates are here to stay and if global deflation sets in, the new negative normal will rule the day.

Thus far, Canada has managed to escape negative rates but this is mostly due to the rebound in oil prices. If, as some claim, oil doubles by year-end, you can expect the loonie to appreciate and the Bank of Canada might even hike rates (highly doubt it). On the other hand, if the Great Crash of 2016 materializes, oil will sink to new lows and the Bank of Canada will be forced to go negative.

Interestingly,  on Wednesday, the Australian dollar plunged almost 2 per cent after a lower-than-expected inflation print  and deflation fears put a rate cut back on the agenda for next week’s Reserve Bank meeting. Keep an eye on the Aussie as it might portend the future of commodity prices, deflation and what will happen to the loonie.

You should also read Ted Carmichael’s latest, Why Does the Bank of Canada Now Believe that Fiscal Stimulus Works?. I agree with him, all this talk of fiscal stimulus is way overblown and in my opinion, it’s a smokescreen for what really lies behind the Bank of Canada’s monetary policy: it’s all about oil prices. And like it or not, the loonie is a petro currency, period.

[As an aside, Ted also shared this with me: “I’d be ok with the budget if they stuck with carefully thought out infrastructure with private sector and/or pension fund participation, but they have blown up the deficit with middle income transfers and operational spending.”]

The rise in oil prices alleviates the terms of trade shock and if it continues, the Bank of Canada won’t need to cut rates this year. It’s that simple, no need to torture yourself trying to figure out the Bank of Canada’s monetary policy, it’s all about oil, not fiscal policy.

South of the border, the Fed will do a cautious dance to avoid volatility:

The Fed is expected to do a cautious dance when it releases its statement Wednesday, as it leaves the door open for a rate hike in June but is not signaling one.

After two days of meetings, the Fed will release a 2 p.m. statement Wednesday. The statement is not expected to be much changed from its last one, but Fed watchers say the nuances will be important. There is no press conference where Fed chair Janet Yellen can provide further clarification, so markets will have only the statement to respond to.

The Fed is expected to be dovish in its statement, but the bond market clearly has been fearing it will be a bit more hawkish, and yields have been rising. Market expectations are for the next rate hike to come early next year, but the Fed has said it expects two rate hikes before then, so there is tension around any statement it would make.

“I don’t think they’re going to tip their hand on the policy section of it. I think the hawkishness might come in their description of the economy, because credit spreads have come back and are no longer a worry. The stock market is no longer down 10 percent on the year. Even the G-20 was less concerned about the economic outlook for the world,” said Chris Rupkey, chief financial economist at MUFG Union Bank.

But the U.S. economic data has been spotty, with more than a few misses recently. Durable goods was weaker than expected Tuesday, and first quarter GDP, expected Thursday, is predicted to be just barely positive.

Fed officials have also been sending mixed messages about rate hikes. For instance, Boston Fed President Eric Rosengren, viewed as a dove, has said the markets have it wrong and are not pricing in enough rate hikes.

“The problem is you’ve got disagreement. The gap has widened,” said Diane Swonk, CEO of DS Economics. “You’ve got dissents. When you have dissents, you have volatility.” Cleveland Federal Reserve President Loretta Mester is expected to join Kansas City Fed President Esther George in dissenting Wednesday, as they object to the Fed’s lack of rate hikes.

“I don’t think they can put the balance of risk back in, because they can’t agree what the balance of risks are,” said Swonk. “It just means continued uncertainty, continued uncertainty for the market.”

Michael Arone, chief investment strategist at State Street Global Advisors, also said the Fed is unlikely to suggest that risks are balanced.

“If they tell you it’s nearly balancing, that’ll be a signal that June is on the table,” said Arone, adding he does not expect to see that.

Arone said the Fed will want to leave options open. “I don’t think this Fed, and Yellen in particular, likes to paint themselves into a corner,” said Arone. “The statement will acknowledge that growth in the economy is modest. They haven’t seen the flow through to inflation and they’ll remain data dependent going forward.”

He said he will be watching to see if Yellen’s view is dominant in the statement. “My view is what Yellen did with her Economic Club of New York speech (March 29), she was saying: ‘I’m the chairperson. This is my view. We’re going to go slow and gradual.’ At the time, other Fed officials were talking about how April was still on the table,” Arone said. “I think what markets are going to be looking to see is if that remains the message or if we’re back in this kind of limbo.”

It will also be important to see if the Fed gives any nod to stability in international markets now that China has calmed some of the fears around its economy.

Besides the Fed, there is the trade deficit data at 8:30 a.m. EDT and pending home sales at 10 a.m. EDT. There is a 10:30 a.m. EDT government inventory data on oil and gasoline, and the Treasury auctions seven-year notes at 1 p.m. auction.

Earnings before the bell include Boeing, Comcast, GlaxoSmithKline, Mondelez, United Technologies, Anthem, Northrop Grumman, Dr Pepper Snapple, Nasdaq OMX, Nintendo, State Street, Tegna, Garmin, Six Flags and General Dynamics. After the bell, reports are expected from Facebook, PayPal, Marriott, SanDisk, Cheesecake Factory, La Quinta, Rent-A-Center, First Solar, Texas Instruments and Vertex Pharmaceuticals.

The only earnings that matter on Wednesday are those of Apple (AAPL). Its shares are down 7% at this writing as it feels the pain of the end of iPhone 6 cycle (they better come up with a great marketing campaign for iPhone 7 to bring the stock back over $120 this fall).

As far as the Fed, I don’t expect any major surprises today but who knows how markets react if the statement turns out to be more hawkish than expected.

More interestingly, Jeffrey Gundlach, the reigning bond king, visited Toronto recently and spoke with Financial Post reporter Jonathan Ratner. Here is an edited version of their discussion which you all MUST read as Gundlach talks about why debt deflation is a real threat, why the Fed capitulated in March and why negative rates are ‘horror’ (read this interview carefully).

Lately, Gundlach has been legging into Treasuries which shows you he’s not worried about any rout in the bond market.

So, if low rates are here to stay, how are pensions going to adapt? More hedge funds? Good luck with that strategy. More private equity, real estate and infrastructure? This seems to be the reigning strategy but pensions have to be careful taking on illiquidity risk, especially if global deflation sets in. And when it comes to private equity funds, they have to monitor fees and performance carefully and also realize real estate has its own set of challenges in this environment.

This is why in Canada, large public pensions are gearing up to bankroll domestic infrastructure, ignoring critics calling this the great Canadian pension heist. By investing directly in mature and greenfield infrastructure, Canada’s large public pensions can put a lot of money to work in assets that offer stable, predictable long-term cash flows, essentially better matching assets with their long dated liabilities without paying huge fees to private equity funds and without taking currency or regulatory risks (still taking on huge illiquidity risk but they have a long horizon to do this).

At the Berkshire Hathaway Inc. annual shareholders meeting over the weekend, Warren Buffett ripped into hedge funds and other investment vehicles associated with investment fees.

He specifically mentioned pension funds’ appetite for those vehicles.

From the Chicago Tribune:

After telling shareholders that he would offer “probably the most important investment lesson in the world,” he said Wall Street salesmanship has masked poor returns for years. Consultants, he added, have steered pension funds and others to high-fee managers who, as a group, underperform what you could get “sitting on your rear end” in index funds. The arrangements “eat up capital like crazy,” he said.

Buffett was building on an argument he’s been making for years about why backing U.S. businesses in aggregate, through low-cost funds, is the more certain way to prosper over the long haul.

[…]

Compounding the problem are middlemen who charge fees to pick managers, Buffett told shareholders.

“Supposedly sophisticated people, generally richer people, hire consultants. And no consultant in the world is going to tell you, ‘Just buy an S&P index fund and sit for the next 50 years,'” he said. “You don’t get to be a consultant that way, and you certainly don’t get an annual fee that way.”

That’s the key to the argument, said Richard Cook, a fund manager in Birmingham, Alabama, who made the trip to Omaha. Buffett still believes that some active investors can beat the S&P 500 over time, Cook said, but in a fund of funds “the fees on fees just destine you to lose.”

Hedge funds have experienced outflows of $16.6 billion over the last two quarters, according to Hedge Fund Research.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andrew Coyne of the National Post warns, Funding government projects through public pension plans a terrible idea:

The federal government, it is well known, is determined to spend $120 billion on infrastructure over the next 10 years. If traditional definitions of infrastructure are insufficient to get it to that sum, then by God it will come up with whole new definitions.

Ah, but whose money? From what source? The government would appear to have three alternatives. One, it can pay for it out of each year’s taxes. Two, it can borrow on private credit markets. Or three, it can finance capital projects like roads and bridges by charging the people who use them. Once these would have been known as user fees or road tolls; in the language of today’s technocrats, it’s called “asset monetization” or “asset recycling.”

Governments at every level and of every stripe have been showing increasing interest in this option, and with good reason. Pricing scarce resources encourages consumers to make more sparing use of them, while confining ambitious politicians and bureaucrats to providing services people actually want and are willing to pay for.

Moreover, by charging users where possible, scarce tax dollars are freed up to pay for the things that can only be paid for through taxes: public goods, like defence, policing and lighthouses.

Of course, if it is possible to charge users, it raises the question of whether the service need be provided, or at least financed, by the state at all. Rather than front the capital for a project themselves, governments can open it to private investors to finance, in return for some or all of the revenues expected to flow from it. As with user fees, this need not be limited to new ventures: “asset recycling” can also mean selling existing government enterprises — what used to be called “privatization.”

Again, there’s much to recommend this. If a project can be financed privately, it usually should, as this provides a truer measure of the cost of capital. (This point eludes many people: since the government has the best credit and pays the lowest interest rate, they ask, doesn’t it make sense to borrow on its account? But by that reasoning we should get the government to borrow on everybody’s behalf. If not, then it is privileging some investments over others, in the same way as if it were to directly subsidize them, and subject to the same critiques.)

The further removed from government, moreover, the less the chances of politicization. There’s a reason we set up Crown corporations at arm’s length from the government of the day, in the hopes of insulating them from politically-minded meddling.

Privatization simply takes that one step further. At the same time, a company in private hands can be regulated in a more disinterested fashion, without the inherent conflict of interest of a government, in effect, regulating itself. Last, experience teaches that when people own something directly, and have an interest in its value, they tend to take better care of it — whereas when the state owns something, no one does.

Yet government and private sector alike are too willing to blur this distinction. Rather than simply put a project out to private tender, with investors bearing all of the risk in return for all of the profit, public and private capital are frequently commingled. All too often, this means public risk for private profit.

That, alas, seems where we are headed — with an extra twist of malignancy. For, as the Canadian Press recently reported, the “private” investors the feds have their eyes on are in fact the country’s public pension plans, notably the Canada Pension Plan’s $283-billion investment fund and Quebec’s Caisse de dépot et placement — much as the Ontario government had earlier suggested it would use its planned provincial equivalent.

This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”

I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.

Even more disquieting is the Caisse’s latest venture, a $5.5-billion light rail project in Montreal, of which the Caisse itself would put up a little more than half — with the remainder, it hopes, to come from the federal and provincial governments.

Is it too hard to imagine, in the negotiations to come, the governments in question suggesting a little quid pro quo: we’ll fund yours if you’ll fund ours?

Well now. If I lend you $100 and you lend me $100, are either of us $1 better off? Now suppose you and I are basically the same person, and you have some idea of the nonsense involved here. The pension plans will fund government infrastructure projects with the money they make on investments funded in part by governments out of the return on investments that were financed by the pension plans and so on ad infinitum.

A government that borrows from others acquires a liability, but a government that borrows from itself may be accounted a calamity.

Poor Andrew Coyne, he just doesn’t get it. Before I rip into his idiotic comment, let’s go over another equally idiotic comment by an economist called Martin Armstrong who put out a post, Asset Recycling – Robbing Pensions to Cover Govt. Costs:

We are facing a pension crisis, thanks to negative interest rates that have destroyed pension funds. Pension funds are a tempting pot of money that government cannot keep its hands out of. The federal government of Canada, for example, is looking to reduce the cost of government by shifting Canada’s mounting infrastructure costs to the private sector. They want to sell or lease stakes in major public assets such as highways, rail lines, and ports. In Canada, they hid a line in last month’s federal budget that revealed that the Liberals are considering making public assets available to non-government investors, such as public pension funds. They will sell the national infrastructure to pension funds, robbing them of the cash they have to fund themselves. This latest trick is being called “asset recycling,” which is simply a system designed to raise money for governments. This idea is surfacing in Europe as well as the United States, especially among cash-strapped states.

This is the other side of 2015.75; the peak in government (socialism). Everything from this point forward is a confirmation that these people are in crisis mode. They are rapidly destroying Western culture because they are simply crazy and the people who blindly vote for them are out of their minds. They are destroying the very fabric of society for they cannot see what they are doing nor where this all leads. Once they wipe out the security of the future, the government will crumble to dust to be swept away by history. We deserve what we blindly vote for.

Wow, “peak government socialism”, “destroying the very fabric of society”, and all this because our federal government had the foresight to approach Canada’s big, boring public pension funds to invest in domestic infrastructure?

These comments are beyond idiotic. Forget about Martin Armstrong, he sounds like a total conspiratorial flake worried about the end of humanity as we know it (not surprised to see him publishing doom and gloom articles on Zero Hedge).

Let me focus on Andrew Coyne, the resident conservative commentator who also regularly appears on the CBC to discuss politics. People actually listen to Coyne, which makes him far more dangerous when he spreads complete rubbish like the article he penned above (to be fair, I prefer his political comments a lot more than his economic ones).

In my last comment on pensions bankrolling Canada’s infrastructure, I praised the federal government’s initiative of “asset recycling” and stated why it makes perfect sense for Canada’s large pensions to invest in domestic infrastructure:

• Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
• Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
• Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they’re avoiding volatile public markets where bond yields are at historic lows and they’re even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes.
• Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada’s large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years.
• What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don’t offer safe, predictable returns.
• Most of Canada’s large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
• Canada’s large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada.
• But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it’s simple logic, not rocket science.
• Of course, if the federal government opens public infrastructure assets to Canada’s large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field.
• Typically Canada’s large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
• But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.

I also stated the following:

No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn’t one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn’t easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec’s taxpayers.

Now, let’s get back to Coyne’s article. He states the following:

This is a truly terrible idea. On the one hand, it offers governments a way to finance their spending on the quiet, without subjecting their plans to the scrutiny of either the credit markets or Parliament. On the other hand, it opens pension funds to pressure to invest in ways that may not be in the best interest of pensioners, but rather of their political “partners.”

And follows up right away with this:

I know, I know: the public pension plans are independent of government, at arms’ length, and all that. But the history of the Caisse is rather less than reassuring in this regard, while the presence of the CEOs of both the Caisse and the CPP Investment Board on the Finance minister’s new economic advisory council does not quite scream independence.

First of all, it’s arm’s length, but leaving that typo aside, what is Coyne talking about? Canada’s large public pensions have a fiduciary mandate to invest in the best interests of their beneficiaries by maximizing their return without taking undue risk. It is stipulated in the law governing their operations and it’s part of their investment policy and philosophy.

Second, Canada’s large public pensions operate at arm’s length from the government precisely because they want to eliminate government interference in their investment process. Importantly, the federal government isn’t forcing Canada’s large public pensions to invest in infrastructure, it’s consulting them to see if they can strike a mutually beneficial policy which will allow the government to deliver on its promise to invest in infrastructure and public pensions to meet their actuarial target rate of return by investing in domestic as opposed to foreign infrastructure (lest we forget their liabilities are in Canadian dollars and there is less regulatory risk investing in domestic infrastructure).

Here you have world class pension experts investing directly in infrastructure assets all around the world and Andrew Coyne thinks it’s shady that Mark Wiseman and Michael Sabia are sitting on the Finance Minister’s economic advisory council? If you ask me, our Finance Minister would be a fool if he didn’t ask them and others (like Leo de Bever, AIMCo’s former CEO and the godfather of investing in infrastructure) to sit on his advisory council.

In the height of the 2008 crisis, I was working as a senior economist at the Business Development Bank of Canada (BDC) and I clearly remember our team preparing that organization’s former CEO, Jean-René Halde, for his Friday morning discussions with then Finance Minister Jim Flaherty. Other CEOs of major Crown corporations (like Steve Poloz the current Governor of the Bank of Canada who was the former CEO of Export Development Canada), were on that call too looking at ways to help banks provide credit and invest in small and medium sized enterprises. There was nothing shady about that, it was a very smart move on Flaherty’s part.

Speaking of shady activity, I have more confidence in the people at the Caisse overseeing the $5.5 billion light rail project than I do with anyone working in the municipal, provincial or federal government in charge of our infrastructure assets. If you want to cut the risk of corruption, you are much better off having the tender offers go through CPDQ Infra than some government organization which isn’t held accountable and doesn’t have skin in the game.

That brings me to another topic. Canada’s large public pensions aren’t in the charity business, far from it. If they’re investing in domestic infrastructure, it’s because they see a fit to meet their long dated liabilities and make money off these investments. And let’s be clear, they all want to make money taking the least risk possible because that is how they justify their hefty compensation.

The notion that any provincial or even the federal government is forcing public pensions to invest in infrastructure is not only ridiculous, it’s downright laughable and shows complete ignorance on Coyne’s part as to the governance at Canada’s large public pensions and their investment mandate and incentive structure.

Andrew Coyne should stick to political commentaries. When it comes to public pensions and the economy, he’s just as clueless as the hacks over at the Fraser Institute claiming CPP is too costly. It isn’t, we should build on CPPIB’s success.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Andy Blatchford of the Canadian Press reports, Liberal government to consider public pension funds to help bankroll mounting infrastructure costs:

The federal government has identified a potential source of cash to help pay for Canada’s mounting infrastructure costs — and it could involve leasing or selling stakes in major public assets such as highways, rail lines, and ports.

A line tucked into last month’s federal budget reveals the Liberals are considering making public assets available to non-government investors, like public pension funds.

The sentence mentions “asset recycling,” a system designed to raise money to help governments bankroll improvements to existing public infrastructure and, possibly, to build new projects.

For massive, deep-pocketed investors like pension funds, asset recycling offers access to reliable investments with predictable returns through revenue streams that could include user fees such as tolls.

“Where it is in the public interest, engage public pension plans and other innovative sources of funding — such as demand management initiatives and asset recycling — to increase the long-term affordability and sustainability of infrastructure in Canada,” reads the sentence in the new Liberal government’s first budget.

Asset recycling is gaining an increasing amount of international attention and one of the best-known, large-scale examples is found in Australia. The Australian government launched a plan to attract billions of dollars in capital by offering incentives to its states and territories that sell stakes in public assets.

Like the Australian example, experts believe monetizing Canadian public assets could generate much-needed funds for a country faced with significant infrastructure needs.

The Liberal budget paid considerable attention to infrastructure investment, which it sees as way to create jobs and boost long-term economic growth. The Liberals have committed more than $120 billion toward infrastructure over the next decade.

Proponents of asset recycling say enticing deep-pocketed investors to join can help governments avoid amassing debt or raising taxes.

“Asset recycling is a way to attract private-sector investment into activities that were formerly, exclusively, in the public realm,” said Michael Fenn, a former Ontario deputy minister and management consultant who specializes in the public sector.

“It’s something that we should pay a lot of attention to and I’m really pleased to see the federal government is looking seriously at it.”

Fenn serves as a board member for OMERS pension fund, which invests in public infrastructure around the world. He stressed he was not speaking on behalf of OMERS or its investments.

Two years ago, Fenn wrote a research paper for the Toronto-based Mowat Centre think-tank titled, Recycling Ontario’s Assets: A New Framework for Managing Public Finances.

In Canada, he said there have been a few examples that resemble asset recycling, including Ontario’s partnership with Teranet to manage its land registry system and the province’s more recent move to sell part of the Hydro One power company.

For the most part, Canada’s big pension funds have been focused on international infrastructure investments because few domestic opportunities have been of the magnitude for which they tend to look.

Australia’s asset-recycling model has been praised by influential Canadians such as Mark Wiseman, president and chief executive of the Canada Pension Plan Investment Board.

“With growing infrastructure deficits worldwide … we often reference this model with our own government and others as one to follow to (incentivize) and attract long-term capital,” Wiseman said in prepared remarks of a September speech in Sydney to the Canadian Australian Chamber of Commerce.

The massive CPP Fund had $282.6 billion worth of assets at the end of 2015. Wiseman’s speech noted more than 75 per cent of its investments were made outside Canada, including about $7 billion in Australia.

Last month, Wiseman was named to Finance Minister Bill Morneau’s economic advisory council, which is tasked with helping the government map out a long-term growth plan. The council also includes Michael Sabia, CEO of Quebec’s largest public pension fund, the Caisse de dépôt et placement du Québec.

In a prepared speech last month in Toronto, Sabia said financial institutions like pension plans have tremendous potential to drive growth through infrastructure investment. For the investor, Sabia said that infrastructure offers stable, predictable, low-risk returns of seven to nine per cent.

A spokeswoman for Morneau’s office was asked about Ottawa’s interest in asset recycling, but she referred back to the budget and said there was nothing new to add on the issue, for the moment.

Last year, I discussed this idea of opening Canada’s infrastructure floodgates. Since then, the idea has taken off and there has been a vigorous push from Ottawa to court pensions on infrastructure.

Why does this initiative of “asset recycling” make sense? I’ve already mentioned my thoughts here but let me briefly make a much simpler case below:

• Federal, provincial and municipal governments are cash-strapped and they need funds to invest in infrastructure. Increasing taxes to do this is simply not a viable option when the economy is weak.
• Unlike other investments, investing in infrastructure has huge long-term economic benefits to any country and infrastructure jobs pay well, which means there is an important multiplier effect to the overall economy from these jobs.
• Pensions need yield. They can invest in public and private markets or in hedge funds. Increasingly, they’re avoiding volatile public markets where bond yields are at historic lows and they’re even starting to shun hedge funds which promise absolute returns but have failed to keep up with simple stock and bond indexes.
• Where are pensions turning to? Private equity, real estate and infrastructure. But unlike private equity, Canada’s large pensions invest directly in infrastructure, avoiding hefty fees to general partners (GPs), and unlike real estate, the duration of infrastructure assets is a better match to the duration of their long dated liabilities which typically go out 75+ years.
• What else? infrastructure assets are highly scalable, meaning these large pensions can put a huge chunk of money to work in one infrastructure investment instead of many private equity or hedge funds which charge big fees and don’t offer safe, predictable returns.
• Most of Canada’s large public pensions target an actuarial rate of 6.3% (nominal), so if Michael Sabia is right and infrastructure offers a stable, predictable and low-risk return of 7-9%, then why not invest directly in infrastructure? It makes perfect sense.
• Canada’s large public pensions are internationally renowned infrastructure investors, investing in airports, highways, ports, and other infrastructure investments all around the world. Their focus has mainly been in Britain and Australia where the rule of law is similar to the one in Canada.
• But if the federal government makes public infrastructure available to them here, either through long-term leases or outright sales, then why not invest in domestic projects, foregoing any currency risk or foreign regulatory risk? Again, it makes perfect sense, it’s simple logic, not rocket science.
• Of course, if the federal government opens public infrastructure assets to Canada’s large pensions, it has to do so for international mega pension and sovereign wealth funds too, introducing competition and leveling the playing field.
• Typically Canada’s large pensions invest in mature infrastructure investments that have been operational for years and offer well-known cash flows, avoiding riskier greenfield projects with uncertain cash flow projections.
• But the Caisse is dipping into greenfield projects here in Quebec. It can do so because it has hired an experienced team of infrastructure professionals with actual operational experience who have project management experience and have overseen previous greenfield projects.

On this last point, the Caisse announced plans on Friday for its Réseau électrique métropolitain (REM), an integrated, world-class public transportation project. Jason Magder of the Montreal Gazette reports, Electric light-rail train network to span Montreal by 2020:

It will be the biggest transit project since the Montreal métro, but this one will be built and mostly funded by a pension fund.

The Caisse de dépôt et placement du Québec, the province’s pension fund manager, unveiled on Friday a light-rail network it intends to build, with the first stations coming online in 2020.

“Every time you take this train, you’ll be paying into your retirement,” said Michael Sabia, the CEO of the Caisse.

Answering decades of demands for an airport link from downtown, the $5.5-billion Réseau électrique métropolitain will be a vast network linking the South Shore, the West Island and Deux-Montagnes to both the airport and the downtown core.

“What we’re announcing today is the most important public transit project in Montreal in the last 50 years,” said Macky Tall, the president of CDPQ Infra, the Caisse’s infrastructure arm.

Leaving from Central Station, the 67-kilometre network will use the track running through the Mount Royal tunnel, taking over the Deux-Montagnes line — which already runs electric trains — from the Agence métropolitaine de transport. New tracks will be built over the new Champlain Bridge, and link to the South Shore, ending near the intersection of Highways 30 and 10 in Brossard. Two other dedicated tracks will be built, branching off from the Deux-Montagnes line, where Highway 13 meets Highway 40. One track will head to Trudeau airport, with a stop in the Technoparc in St-Laurent. Another will follow Highway 40 toward Ste-Anne-de-Bellevue. The existing Vaudreuil-Dorion train line won’t be affected by the project.

Light rail trains are smaller and carry fewer passengers, but the service will be more frequent than the current AMT service, Tall said.

This is not the pension manager’s first foray into public transit. The Caisse is one of the builders of the Canada Line, a train that links Vancouver’s airport to the downtown area and the suburb of Richmond. It was built in time for the 2010 Olympic Games.

However, Sabia admitted this project represents a much greater risk, since the Caisse is the principal investor and has to recoup both its capital investment and its operating costs. But he’s confident the Caisse will achieve “market competitive returns” on the project.

“We are taking the traffic risk here,” Sabia said. “This is unusual because generally, it’s governments that take that risk.”

Matti Siemiatycki, an associate professor of urban planning at the University of Toronto, said this is a first for Canada, so it’s an untested funding model.

“Internationally, there have been privately funded and financed commuter rail lines, but in most cases, they don’t recover their operating costs, let alone their capital costs,” Siemiatycki said.

He said because it has holdings in engineering, train manufacturing and train operating companies, the pension fund does have an advantage. But he’s not sure it will be enough.

“It’s possible they can realize economies, but it doesn’t take away the fact that most transportation systems in North America are not recovering their operating costs, let alone their capital costs, so that will be the Caisse’s challenge,” he said.

Sabia said the Caisse intends for most of the revenue to come from fares, which he said will be similar to the ones currently charged by the AMT.

“That’s a big chunk of it but, of course, as you know municipalities today have made a public policy decision to encourage people to use public transit,” Sabia said. “We would expect that current practice would continue and contribute to the overall financing of the project.”

Because the trains will be fully automated, Sabia said the operating cost of the network will be low.

The Caisse, which has a real-estate investment division, will also try to recoup some of the investment through development along the line, but Sabia said the bulk of the revenue will come from ridership. The Caisse expects a daily ridership of 150,000, compared with 85,000 that currently use the Deux-Montagnes line, the 747 airport bus and buses across the Champlain Bridge.

The Caisse has promised trains will leave every three to six minutes from the South Shore and every six to 12 minutes on the West Island and Deux Montagnes Line, for the duration of its 20-hour operation schedule from 5 a.m. to 1:20 a.m. The Caisse estimates it will take 40 minutes to take the train from either Ste-Anne-de-Bellevue or Deux-Montagnes to downtown. It will take 30 minutes to go from Central Station to the airport. It will take between 15 and 20 minutes to travel from Brossard to downtown.

Tall said the decision to follow Highway 40 was made because of work going on in the Turcot Interchange. That work would have prevented crews from building dedicated lines for the next five years. He said building along that corridor would also cost $1 billion more because it would require a track dedicated to passenger traffic.

The thorny issue of parking remains unsolved, however. Currently, many stations along the Deux-Montagnes line are over capacity and there is no space to build new parking spots.

Tall said the Caisse will speak with municipalities about this issue and hopes to come up with a solution.

Michael Sabia has gone from being an outsider to a rainmaker in Quebec. When he took over the provincial pension fund, it was $40 billion in the hole. He’s managed to grow its asset base by $130 billion since then and is now looking to invest directly in Quebec’s infrastructure with this “risky” foray into a greenfield project.

I put “risky” in quotations because unlike that associate professor of urban planning quoted in the article above, I’m more optimistic and think he is underestimating Macky Tall, CEO of CDPQ Infra and his senior team, many of whom have worked on greenfield infrastructure projects and know what they’re doing when it comes to managing such large scale projects. No other large Canadian pension fund has as much operational experience when it comes to greenfield infrastructure projects, which is why they typically avoid them.

So, while Sabia garners all the attention, there are a lot of people under him who deserve credit and praise for this huge project. One of them is a friend of mine who has nothing but good things to say about Michael Sabia, Macky Tall, CDPQ Infra’s team and the Caisse in general.

No doubt, greenfield infrastructure projects carry bigger risks but they also offer bigger rewards down the road. Will everything go smoothly in this project? Of course not, there isn’t one major greenfield infrastructure project that goes off without a hitch but the people working on this project have actual operational experience and a track record of delivering on such projects below budget (which isn’t easy) easing my concerns about recouping operating and capital costs.

So, I would tell the media and critics to ease up and have faith in Macky Tall and his team at CDPQ Infra. They are all very experienced and highly ethical individuals who will deliver on this and other greenfield projects if they are asked to in the future. And trust me, there will be no Charboneau Commission on this project which is great news for Quebec’s taxpayers.

A line Canada’s federal budget reveals that lawmakers are considering selling and leasing stakes in the country’s infrastructure to public pension funds as a mechanism for infrastructure improvements, according to the Canadian Press.

Pension360 previously wrote that several of the country’s largest public pension funds – which are, not coincidentally, some of the largest infrastructure investors in the world, had an appetite for such an arrangement.

More from the Canadian Press:

A line tucked into last month’s federal budget reveals the Liberals are considering making public assets available to non-government investors, like public pension funds.

The sentence mentions “asset recycling,” a system designed to raise money to help governments bankroll improvements to existing public infrastructure and, possibly, to build new projects.

“Where it is in the public interest, engage public pension plans and other innovative sources of funding — such as demand management initiatives and asset recycling — to increase the long-term affordability and sustainability of infrastructure in Canada,” reads the sentence in the new Liberal government’s first budget.

[…]

Australia’s asset recycling model has been praised by influential Canadians such as Mark Wiseman, president and CEO of the Canada Pension Plan Investment Board.

“With growing infrastructure deficits worldwide … we often reference this model with our own government and others as one to follow to incent and attract long-term capital,” Wiseman said in prepared remarks of a September speech in Sydney to the Canadian Australian Chamber of Commerce.

Infrastructure investments are a strong fit for public pension funds because they are long-term and offer reliable, steady returns.

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at Calpensions.com.

Should CalPERS continue a 16-year-old ban on highly profitable tobacco investments or consider reinvesting after a lengthy study, risking a public-relations black eye and controversy?

A committee with all 13 CalPERS board members narrowly approved a staff proposal last week to begin a two-year review of tobacco investments, including outreach to members and others and an economic study costing $500,000 in an initial estimate.

But at the request of state Treasurer John Chiang, a board member and potential Democratic candidate for governor, the chairman of the investment committee, Henry Jones, agreed to reconsider the tobacco issue next month.

“Investing in tobacco companies is harmful to public health and to our fiscal bottom line,” Chiang said in a news release. “Smoking causes addiction, disease and death. No public pension fund should associate itself with an industry that is a magnet for costly litigation, reputational disdain, and government regulators around the world.”

The push from the state treasurer was an echo of the original decision in 2000 to ban tobacco investments. The state treasurer at the time, Phil Angelides, who made an unsuccessful run for governor four years later, led the drive for divestment.

The main argument for the ban (approved with a one-vote margin like the review last week) was that tobacco would be an unprofitable investment due to litigation, regulation, and massive health-related settlements with state and local governments.

CalPERS had a surplus then and had infamously, in the view of critics, told the Legislature the previous year that a large retroactive pension increase for state workers, SB 400 in 1999, would not cost “a dime of additional taxpayer money.”

Now CalPERS is underfunded, with 74 percent of the assets needed to pay future pensions in the last report, and concerned that another major economic downturn, like the last one, could drop funding to 50 or 40 percent, making a return to full funding unlikely.

And despite the bleak outlook in 2000, tobacco has been one of the most profitable investment sectors. (see chart below) Analysts say tobacco stocks perform well in downturns, have growing sales in developing nations, and steadily pay big dividends.

“If a large enough proportion of investors avoids sin businesses, their share prices will be depressed, thereby offering the prospect of elevated returns to those less troubled by ethical considerations,” a Cambridge University professor, Elroy Dimson, said in a Credit Suisse report last year on “sin” business investments.

Tobacco’s burden is more than stigma. In 1998, four U.S. tobacco companies agreed to pay $246 billion over 25 years to settle about 40 lawsuits by states to recover medical service costs for smoking-related diseases.

California is one of the states that issued bonds that will be paid off by the tobacco money. A state treasurer’s report in 2007 said California had sold $16.8 billion worth of tobacco securitization bonds, $3.6 billion by 28 local agencies and the rest by the state.

California voters approved a 25-cents-per-pack tobacco tax, Proposition 99 in 1988, for a program to prevent and discourage the use of tobacco. In November 2012 voters narrowly rejected a $1-per-pack tax for cancer research, 49.8 to 50.2 percent.

This year, signatures are being gathered to place a $2-per-pack tobacco tax for public health care on the November ballot.

The new initiative is backed by a union representing public health care workers, SEIU, and Tom Steyer, a billionaire former hedge-fund manager, environmentalist and Democratic campaign donor, who is mentioned as a potential candidate for governor.

An analysis of the California Public Employees Retirement System divestment policy last fall found that the tobacco ban had cost $2 billion to $3 billion through 2014, depending on the methodology used, Wilshire consultants said.

CalPERS staff concluded that the cost of other divestments related to Iran, Sudan, firearms, and emerging market principles are relatively minor (in an investment fund valued at $296 billion last week) and could be reviewed under a general policy.

But the tobacco loss was deemed large enough to merit a separate review. The rationale for the new look at tobacco is the “fiduciary duty” CalPERS board members have under the state constitution to act in the best interests of pension recipients.

A union-backed constitutional amendment, Proposition 162 in 1992, a response to a state budget “raid” on CalPERS funds, made paying pensions the top priority of public pension boards, ahead of what had been an equal goal of minimizing employer costs.

A staff agenda item last week said the constitution states, among other things, that the CalPERS board “ . . . shall diversify the investments . . . so as to minimize the risk of loss and to maximize the rate of return . . .”

A substitute motion by Treasurer Chiang’s representative on the CalPERS board, Grant Boyken, to reject the review and reconsideration of tobacco investments failed on a 6-to-5 vote with one abstention.

“While my heart would absolutely love to support the substitute motion,” said board member Priya Mathur, “I think from a fiduciary perspective process is everything, and it’s really important that we engage in a robust process to review something that has substantial financial implications for the portfolio.”

Mathur’s successful motion called for an expert long-term economic study of tobacco, outreach and education to stakeholders for their input, learning how other institutional investors have offset tobacco losses, and alternatives to tobacco divestment.

The motion also scheduled a board discussion of tobacco divestment in January 2018 and a vote the following the month. Reviews of non-tobacco divestments would be triggered if losses exceed a threshold to be set later.

In the 7-to-4 vote with one abstention, voting “yes” were state Controller Betty Yee, Mathur, Bill Slaton, Dana Hollinger, Rob Feckner, Ron Lind, and Theresa Taylor. Voting “no” were Chiang, J.J. Jelincic, Michael Bilbrey, and Richard Costigan.

Katie Hagen, representing Human Resources director Richard Gillihan, abstained. Following CalPERS custom the committee chairman, Henry Jones, only votes to break a tie.

The California State Teachers Retirement System added a 21st risk factor to its investment policy as the basis for tobacco divestment: an industry product harmful to human health that results in lawsuits, regulation, and avoidance by other investors.

CalSTRS eliminated most tobacco investments by changing its benchmarks in 2000, then completed the divestment in 2009 by banning tobacco investments by active managers. A spokesman said tobacco divestment has cost CalSTRS more than $4 billion.

“CalSTRS is a patient, long-term investor, and the ultimate economic impact of divestment from tobacco cannot yet be determined,” Jack Ehnes, CalSTRS chief executive officer, said in a blog post on Aug. 21, 2013.

“Similarly difficult to assess is the social impact of this action,” he said. “What we do know is that CalSTRS no longer exerts institutional strength in this market sector and cannot attempt to leverage that financial strength to achieve reform.”

A hearing this week in Texas’ House Appropriations Committee shed some light onto the state’s pension funding situation – and the funding limitations that are baked into state law.

Keith Brainard of the National Association of State Retirement Administrators (NASRA) testified that the lower and upper bounds of Texas’ annual pension contributed are defined by law.

From the Houston Chronicle:

Texas — unlike Arizona, Louisiana, Maine and Montana – has set constitutional limits on how much the state will contribute to pension plans: no less than 6 percent and no more than 10 percent of the plan’s cost.

“Texas is the only state in which the constitution limits the state’s ability, the employer’s ability to adequately fund its pension plan,” Brainard said.

That point is critical because of the mounting obligations of the four current pension plans for state employees, of which only one is a pay-as-you-go plan. According to the Employee Retirement System, the debt obligation is $8 billion and growing.

Two rounds of benefit adjustments and an infusion of state cash last session under House Bill 9 have only slowed the growing obligation. Outgoing Appropriations Chair Rep. John Otto, R-Dayton, has pressed hard on the issue of a lump sum appropriation, or increased contribution, to defray the cost of current obligations: The Legislative Budget Board has said no while ERS has said yes.

What is not in doubt is the heavy blow long-term financing will be. Porter Wilson, the new executive director of ERS, noted the current trajectory of funding would pay off current obligations in 2048, at a cost of $29.1 billion. Pump in $1 billion and that obligation drops to $20.7 billion; $4 billion will be $11.7 billion; and an $8 billion infusion would cost $9.5 billion and actuarial soundness in 2018.

View the hearing presentations here.

CalPERS on Wednesday postponed a plan to study whether it should re-invest in tobacco-related assets after divesting from such assets 15 years ago.

On Thursday, the pension fund also approved a contribution rate increase for state government and school districts.

The Sacramento Bee reports on the postponement of the tobacco study:

The big California pension fund Wednesday unexpectedly postponed a plan, adopted two days earlier, to launch an extensive study of whether it should reinvest in tobacco company stocks. Instead, the CalPERS investment committee will discuss the issue again May 16, said CalPERS spokeswoman Rosanna Westmoreland.

On Monday, the investment committee voted to begin a 12- to 24-month study of the pluses and minuses of tobacco investments. The vote followed a consultant’s report saying the California Public Employees’ Retirement System had sacrificed $3 billion in profits by deciding in 2001 to dump its tobacco holdings.

The investment committee consists of every CalPERS board member. As a result, approval by the full board usually is a formality. But this time it wasn’t. The representative for State Treasurer John Chiang, who opposed Monday’s decision, asked investment committee chairman Henry Jones to hold off until next month. Jones, who is also vice president of the full board, agreed.

“No public pension fund should associate itself with an industry that is a magnet for costly litigation, reputational disdain and government regulators around the globe,” Chiang said later Wednesday in a prepared statement.

A different report from the Bee also outlines the rate increase:

The state’s contribution will increase by an estimated $602 million, to $5.4 billion a year. School districts will be charged an additional $342 million, to a total of nearly $1.7 billion a year. While teachers are covered by CalSTRS, other school employees get their pensions from CalPERS.

It’s the latest in a series of rate hikes implemented by the California Public Employees’ Retirement System in recent years, primarily to cover longer retiree lifespans, salary increases and the growing pool of state and school district employees. CalPERS is also dealing with lingering financial fallout from the 2008 financial crash, which cost the pension fund tens of billions of dollars.

The rate increase is smaller than initial projections, according to CalPERS.

Late last month, a federal judge ruled that private equity funds are liable for the pension debt of their portfolio companies.

Observers say the ruling could shake up the private equity industry.

The legal nuts and bolts are outlined in this Lexology article; but a New York Times piece provides a more down-to-earth explanation of what this means for private equity:

Late last month, Judge Douglas P. Woodlock of the United States District Court in Massachusetts found that two private equity funds were jointly liable for the pension fund debt of one of the companies they acquired.

“The private equity world is all over this,” said Paul Secunda, a labor law and employee benefits expert at Marquette University Law School. “For everybody else, it’s like, what’s the big deal?”

To answer that, it helps to go back to the beginning of the story.

It started with a Rhode Island company, Scott Brass, which makes brass and copper for all sorts of industries. In 2007, an affiliate of the private equity firm Sun Capital Partners bought Scott Brass, splitting the ownership between two separate Sun Capital funds.

A year later, Scott Brass went bankrupt and stopped contributing to its pension fund, run by the New England Teamsters and Trucking Industry Pension Fund.

Federal law imposes pension liability on any “trade or business” that is under “common control” with Scott Brass. The pension fund argued that Sun Capital’s funds met that definition — and should be liable for the $4.5 million pension fund debt.

In 2013, the United States Court of Appeals for the First Circuit found that one of Sun’s funds did constitute a “trade or business” — the first time a private equity fund was classified as such. The appeals court sent the case back to a lower court to decide whether Sun’s other fund was “a trade or business” as well.

On March 28, Judge Woodlock found not only that the other fund’s activities met the test of being “a trade or business,” he also found that the two funds served as a “partnership in fact” — one that was under common control with Scott Brass. That made the funds liable for the pension debt.

And what does the ruling mean, if it’s upheld? From the New York Times:

Two years ago, the appeals court’s opinion drew a flurry of attention over whether the Sun Capital case would challenge the foundation of the private equity business model by changing how it is taxed. That’s because the appeals court relied on federal income tax principles to conclude that Sun’s private equity fund was a “trade or business” for the purposes of employee benefits law.

In theory, if the I.R.S. were to adopt the same reasoning in a tax context, it could kill the goose that lays the golden eggs of the private equity industry: its huge tax breaks. It could do it in a way that would turn the investing world upside down.

And that’s why it probably will not happen, said Gregg D. Polsky, a tax law professor at the University of North Carolina School of Law who has written critically about the industry’s practices.

“It could create all sorts of potential headaches and uncertainties for investors,” Professor Polsky said, including foreign investors and tax-exempt investors like university endowments. “I don’t think the I.R.S. is interested in doing that.”

Until now, private equity firms have looked at companies with underfunded pension plans as undervalued targets, because the private equity firms were not responsible for funding those plans once they took over the company. Now they know they might be if Judge Woodlock’s ruling is upheld on appeal, and if other courts adopt it.